January 23, 2009

The ETF industry has the enemy in its sights: It's the active manager who runs a traditional equity mutual fund. When they first appeared in the marketplace, ETFs -- exchange-traded funds -- talked up such virtues as their lower costs, tax advantages and how easy they were to trade. Now, after the worst year for the Dow Jones industrial average since 1931, they’re going in for the kill.

“Active managers say they'll protect you when the market falls by getting ahead of it,” says Lee Kranefuss, chief executive officer of Barclays Global Investors’ Shares business. “That promise is hard to deliver on.” ETFs are not only cheaper, he says, they outperform the managers, too.

An ETF is a mutual fund that you buy and sell through a brokerage account, like an individual stock. Most ETFs are index funds -- meaning they track the performance of a particular market, or slice of the market, rather than try to exceed it.

In theory, active managers should beat indexes because their funds can build up cash during a market drop. Theyíre also supposed to be able to pick the stocks that will hold up better during declines. That’s one of the things you pay them for.

Theyíre not earning their pay. Last year, 58 percent of all actively managed funds lost more in value than the benchmark they measure themselves against, according to Morningstar. That’s not much better than chance. Small-cap managers, who are supposed to be especially nimble, had a particularly bad year: 72 percent of them fell behind their benchmarks.

Beating the indexes

The numbers get worse when you compare the managers' performance with the Standard & Poor’s 500 Index. Among large-cap U.S. funds, 62 percent lagged behind the S&P in 2008, as did 63 percent of all U.S. diversified equity funds.

Most managed funds trailed the indexes in the first phase of a recovery, too. As an example, look at what happened in the 12 months starting in October 2002, the bottom of the last bear market. Seventy-eight percent of U.S. managed equity funds did worse than the benchmark they measured themselves against. You are paying your managers to miss.

Investors are catching on. They pulled $128.7 billion out of managed equity mutual funds in the first 11 months of 2008, according to the Investment Company Institute in Washington, but didn't give up on stocks entirely. During that same period, they put $20.8 billion into traditional index funds. Exchange-traded products attracted $133 billion.

“Any time the market is struggling, investors are more likely to notice the drag on performance caused by the fees active managers charge,” says Jim Wiandt, publisher of IndexUniverse.com. “That pushes them toward indexing in general and ETFs in particular,” he says.

Tax planning

In December, ETFs accounted for 38 percent of all equity trades by dollar value on the NYSE Arca, up from 32 percent in the third quarter. A majority of the volume is coming from large investors, including institutions and hedge funds, Wiandt says.

Retail investors are playing, too, especially for year-end tax planning. They were selling traditional mutual funds, booking the loss, and staying in the market by buying a similar ETF.

Christy White, a principal of the consulting firm Cogent Research in Cambridge, Mass., says that ETFs are attracting Generation X investors, now in their 30s and 40s, who tend to be more self-directed than older generations. ETFs also interest high-net-worth investors, who use them in place of individual stocks for broad exposure to market segments. As any money manager can tell you, picking stocks is hard.

ETFs for industry sectors gain or lose investors as market sentiment changes. Right now, Financial Select Sector SPDR is getting a lot of play. Sector ETFs simplify your life, because you don't have to research each stock separately, says Tom Lydon, editor of EFTtrends.com and co-author (with my Bloomberg colleague John Wasik) of “Money: Profitable ETF Strategies for Every Investor.”

ETFs have two other things going for them, besides performance. They charge lower annual fees than managed funds do and, in most cases, they offer an edge to taxable investors. ETFs rarely distribute taxable capital gains during the time you hold the investment, as many traditional funds do. You usually (but not always) don't have to book any gains until you sell your shares.

Cutting trading costs

In one investment sector, the major ETFs fall behind. They usually don't beat low-cost traditional index funds, such as those offered by the Vanguard Group and Fidelity Investments. These funds not only charge low fees. You can also can add to them, reinvest dividends, and make withdrawals without paying brokerage commissions or other trading costs.

Where ETFs shine is against the higher-cost managed mutual funds.

Scott Burns, director of ETF analysis at Morningstar, says that indexing usually grabs more market share during slowdowns, when managers underperform. But when stocks turn up again, a certain percentage of retail investors goes back to chasing funds that they think can beat the market. “To be an index investor takes a great amount of discipline,” Burns says. But worth it, in the end.

Quinn, a leading personal finance writer, is a Bloomberg News columnist. She is a director of Bloomberg LP, parent of Bloomberg News.